Citi shares, which were recently trading at $3.14 a share, now have more than tripled from a low of $1 reached on March 5.

Arbitragers say that Citi shares are virtually impossible to short now because of heavy demand from those who had set up an arbitrage in which they bought Citi preferred and shorted the stock after the banking giant announced the exchange offer on Feb. 27.

Traders say that Citi shares could fall once the exchange offer is complete, which is expected in about a month. That's because of the dilution created by the additional common shares.

Citi is expected to file information on the exchange offer with the Securities and Exchange Commission in the next few days.

In a bid to boost its depleted tangible common equity, Citi announced an exchange offer involving some $25 billion of preferred held by the government under the TARP program, some $12.5 billion of preferred held by a group of private investors, including Saudi Prince Alaweed, and $14.9 billion of publicly held preferred.

Citi shares fell sharply in the wake of that announcement, dropping to under $1 from $2.50 as investors banked on massive dilution of existing common holders. Citi's shares outstanding are expected to rise to about 22 billion from 5.5 billion once the roughly $52 billion of preferred is converted into common shares. The preferred exchange offer is voluntary but the vast majority of public holders are expected to participate. The Treasury Department also is planning to participate.

Arbs who initially bought Citi preferred and shorted Citi common banking on earning a roughly 10% spread until the deal closed now are facing huge losses with one arb calling the situation "a death march." Citi's actively traded series P preferred now trades around $13.50, way below the exchange value of the preferred of about $20. Holders of the series P preferred will get 7.31 shares of Citi common for each preferred share, which has a face value of $25.

Right after the exchange offer was announced, the series P preferred traded around $8, roughly $1 below the value of the common shares offered in the exchange. That spread has widened to $6.50, badly stinging any arbs who are long the preferred and short Citi.

The talk is that JPMorgan yesterday urged investors interested in owning Citi to buy the preferred, not the common, given the big discount on the preferred. A buyer of the series P preferred can effectively create Citi shares below $2 a share, indicating that Citi may trade lower once the exchange offer is done.

Some wonder why a stock in which there are 5.5 billion outstanding shares is tough to borrow. For starters, many firms are reluctant to lend shares that trade below $5 a share. And many institutional investors are unwilling to lend out their securities in the wake of the collapse of Lehman Brothers amid fears of counterparty risk.

The bottom line is that a massive short squeeze in Citi appears to be a major factor behind the sharp rise in the stock. It's true that financials have rallied recently, but the gain in Citi has been outsized relative to its peers. For those bullish on beleaguered Citi, its preferred, including the series P issue and three other issues, looks like the best bet.